LME is virtually Chinese now

The iconic London Metals Exchange (LME), world’s oldest market for industrial metals, may soon become virtually Chinese. The Hong Kong Exchanges and Clearing Ltd (HKE), world’s second-biggest bourse by market value, has offered to buy it for more than $2 billion, which makes LME the most highly valued commodity exchange in the world, for now.

But why is the 135-year old LME up for sale and why is HKE so keen to buy it? The answer lies in the very business of commodity exchanges.

Commodity exchanges make money mainly from the fees they charge people for trading on their platform. The fee collected rises in direct proportion to the number and value of contracts traded. All was well till the 2009 commodities bullrun. Index traders, large funds, banks, and companies were all discovering the value of adding commodities to their portfolio. Then the world economy flipped. The funds and banks have had to rejig their portfolios. Gold and crude oil have retained punter interest but the bets are fewer in metals and farm commodities as the global economy slows down.

The upshot of this reversal is that every major exchange around the world is caught in the breakneck race to ramp up business. The game plans are a mix of four strategies: introduce more attractive contracts; walking into a new geography; trading longer hours with lower fees; and buying successful rivals.

LME is a classic case. As long as Britain was the hub of the industrial world, LME was its natural marketplace. Now China is the world’s biggest metals economy and largest gold buyer. Until three years ago, LME dominated trade in the six base metals setting the global pricing benchmark, but arrival of more active Chinese traders and US-based funds changed the game. Net profits fell 19% last year and its current market share is 65%, down from 88% in 2006.

Merger with the HKE would give the LME a fast track into China, and strengthen its position against rival Shanghai Futures Exchange, which also trades in base metals. LME’s acquisition will allow HKE to add commodities to its equities business at a time when the IPO market is dull. Clearly, the LME and the HKE need each other.

US exchanges are engrossed in a dog fight. The other bidder for the LME, the IntercontinentalExchange Inc (ICE), operator of the New York commodity derivatives markets, is itself product of a string of acquisitions from the London-based International Petroleum Exchange in 2001 through the New York Board of Trade and, most recently, a climate exchange and a stake in a Brazilian clearing house.

ICE has been hugely successful in launching “lookalike” contracts to beat rivals it couldn’t buy. After a failed bid to buy NYMEX, six years ago, ICE listed a crude oil contract based on NYMEX’s prices. The contract thrived, gaining up to one-quarter as much daily volume as the NYMEX.

ICE is now launching contracts based on the CME Group’s Chicago Board of Trade, which operates the world’s benchmark contracts in corn, soyabeans and wheat. It is also introducing 22-hour trading and offering its contracts at lower margins than CBoT, meaning investors need to put down less collateral against dealing. The CME Group has responded with its own plans for 22-hour dealing and new options contracts.

NYSE Euronext, which runs Europe’s top agricultural derivatives markets besides the New York and Euronext stock exchanges, last week unveiled a new logo which “conveys the dynamism of NYSE Euronext’s markets”. A scrum is on in India too. There are 21 commodity exchanges (16 regional and five national exchanges). Business volumes have been virtually stagnant from October 2011 onwards, data from regulator Forward Markets Commission shows. Since national exchanges have a 99% share of the market, regional players are fighting for crumbs.

Among national exchanges, MCX and Ncdex together have 93% share because traders prefer doing business in the biggest market place to get the best deal quickly. Promoters of new exchanges may have planned to ramp up the business, get a great valuation and exit rapidly. But current low volumes are a turn-off for potential buyers, forcing them to trudge on. MCX, which receives most of its business from “lookalike” contracts in bullion, metals and energy, can’t hope to remain immune to the global turbulence. Ncdex, the largest market for farm commodities, is under pressure from government moves to control food prices. In short, growth is a daily struggle.

The very life of a commodity exchange depends upon creating a crowded market place. It has to continuously pique trader interest or die. The rapidly changing global economy guarantees more fast-paced action in the coming months. As LME’s sale shows, history counts for little in the futures business.